Pimco’s Gross: Lousy Risk/Reward Trade-off For Bonds Today

By Michael Aneiro

Bloomberg News

Cat bonds.

Pimco‘s Bill Gross is out with his latest monthly investment outlook piece, this one titled “Bob” after his recently deceased female cat of the same name, whose eulogy occupies the first three paragraphs. Gross then turns to a discussion of Sharpe ratios among asset classes over the past decade and a half (roughly the cat’s lifespan), which he then uses to frame a discussion of a bond market measure of risk/return known as “yield per unit of duration.” Here’s Gross:

[T]oday’s reward relative to risk – yield per unit of duration is more or less half of what it has been for the past 15–20 years. In order to get the same yield today for a single unit of duration for AAA, BBB, and HY bonds, an investor has to take twice the price risk! Since duration and correlated maturities are simply measures of interest rate risk, that may simply be pointing out that yields are historically low, and yes – they still are. But in order to capture other elements of return such as credit, curve, volatility and currency, the average bond investor must generally attach those elements of “carry” to a bond with a duration. Swaps, CDS, and FRN’s provide a partial escape but for the cash investor, today’s yield per unit of duration is only half of the markets’ 15–20 year historical measure, and that is very, very low dear reader.

Gross suggests there are two opposite approaches to addressing this: Either double your duration and maintain the same historical yield, or maintain your duration “as a concession to an overpriced market that may continue to suffer increasing yields and lower prices.” Which leads to Gross’s investment recommendations:

PIMCO recommends overweighting credit and to a lesser extent volatility and curve. Underweight duration. Although credit spreads are tight, they are not as compressed as interest rates, which are now in the process of normalization. While PIMCO agrees with Janet Yellen that such normalization will be a long time coming (the 12th of Never?), probabilities suggest that as the Fed completes its Taper, the 5–30 year bonds that it has been buying will have to be sold at higher yields to entice the private sector back in. The 1–5 year portion of the curve, beaten up recently due to Fed “blue dot” forecasts and Yellen’s “six months after” comments, should hold current levels if inflation stays low, but 5–30 year maturities are at risk.